Interpreting Final Accounts

After studying this section you should be able to:

• explain the difference between profitability, liquidity, efficiency and debt/gearing
• calculate the main accounting ratios
• reach appropriate conclusions on the basis of your calculations

Final accounts and their interpretation

Although accounts must be kept for external purposes, e.g. to assess and calculate the firm’s tax bill, one result of keeping these financial records is to allow analysis to take place. This analysis has:

• an internal focus, when the firm compares its present performance with past records in order to establish trends and to indicate efficiency
• an external focus, when the firm assesses its competitiveness by comparing results with other organisations in the same industry.

Profitability

Profitability measures a firm’s total profit against the resources used in making that profit. On its own, profit is a relatively meaningless figure: it needs comparing against figures such as turnover and capital employed.

Profitability ratios

Return on capital employed (ROCE) = net profit / capital employed x 100

This shows the profitability of the investment by calculating its percentage return. The return shown can then be compared with the expected return from other investments. The normal figure used by companies is profit on ordinary activities  before taxation rather than after tax (the tax charge may vary from year to year, so using profit after tax would not lead to comparing like with like). If PBIT – profit before interest and tax – is used, the profit figure is compared with capital employed, i.e. share capital plus long-term loan capital.

ROCE can be sub-divided:

ROCE = Profit margin × Asset turnover

PBIT / capital employed = PBIT / sales × sales / capital employed

The profit margin ratio (see below) shows whether the company is making a low or a high profit margin on its sales; the asset turnover ratio measures how efficiently the company’s net assets are being used to generate its sales.

Gross profit margin (GP ratio, or GP %) = gross profit / turnover x 100

This indicates the percentage of turnover – net sales (sales less VAT and any returns) – represented by gross profit. If the gross profit margin is 30%, this means the firm’s cost of sales are 70% of its turnover (because turnover = cost of sales + gross profit).

Net profit margin (NP ratio, or NP %) = net profit / turnover x 100

This shows the percentage of turnover represented by net profit, i.e. how many pence out of every £1 sold is net profit. The NP margin will fall if the GP margin has fallen and rise if the GP% has increased: but it is also affected when the firm’s other expenses as a percentage of turnover have changed.

Liquidity

Liquidity is the amount of cash a firm can get quickly in order to settle its immediate debts. Although a firm can survive in the short term without profit, it cannot survive for long without sufficient liquidity. Liquid funds consist of:

• cash in hand and at bank
• short-term investments and deposits
• trade debtors.

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The cash (or ‘operating’) cycle

Examining the cash cycle shows the following:

• the timing of cash flows will not necessarily coincide with sales and purchases (cost of sales) – allowing and taking credit will cause this difference
• delays also occur with cash receipts, through allowing credit or increasing the credit period, and by holding additional stock
• cash payments may be delayed through taking credit.

Liquidity ratios

Liquidity ratios help establish whether a firm is overtrading, expanding without sufficient long-term capital. This puts pressure on its working capital, the excess of current assets over current liabilities.

Working capital (current) ratio =  current assets (CA):current liabilities (CL)

If current liabilities exceed current assets, the firm may have difficulty in meeting its debts. Extra short-term borrowing, to pay off creditors, costs the firm money (interest). If the firm sells assets to help meet its debts, it risks loss of production and future expansion.

Liquid ratio (‘Acid test’ or ‘Quick assets’) = CA minus stock:CL

Using this ratio lets us see whether the firm can meet short-term debts without having to sell stock, which is regarded as the least liquid current asset (and the prudence concept encourages accountants to assume the firm will not automatically sell – realise – its stock).

1:1 seen as ideal

Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance

If it is too low then the business may face working capital problems

Some types of business need more cash than others so acid test would be expected to be higher

Debtors’ collection period (‘Debtor days’) = debtors / sales x 365

This liquidity (or efficiency) ratio shows the time, measured in average days, that it

takes debtors to pay the firm.

Creditors’ collection period (‘Creditor days’) = creditors / purchases x 365

This ratio calculates the average length of credit the firm receives from its suppliers.

‘Window dressing’

This term is used to describe techniques for improving a company’s balance sheet position, in particular its apparent liquidity. Examples include:

• paying additional money into the bank account just before the year end, in order to boost the cash balance (the amount is then withdrawn later)
• using inter-group transfers – one cash-rich company in a group forwards a cheque to another group company with an overdraft, then cancels the cheque after the year end (this hides the other company’s overdraft, which would otherwise have to be shown in the group accounts)
• undertaking sale and leaseback just before the year end.

SSAP 17, Accounting for post balance sheet events, helps control window dressing by forcing companies to reverse transactions taken before the year end, if these transactions were made to alter the appearance of the company’s balance sheet. Liquidity, associated with cash flow, measures the firm’s ability to survive in the short run. Profitability is a clearer indicator of its ability to survive in the longer term.

Asset efficiency

Firms need to use their assets as efficiently as possible. The efficiency of both current and fixed assets can be measured.

Asset efficiency ratios

Rate of stock turnover (‘Stockturn’) = cost of sales  / average stock (stated as ‘ … times per period’)

The purpose is to calculate how frequently the firm sells its stock: if stock turnover is slowing, the firm is holding more stock than before, it may be facing problems selling its products, or it may have bought additional stock to take advantage of discounts offered.

An alternative calculation to display ‘stock days’ is average stock / cost of sales x 365

This is a useful analysis when used in conjunction with debtor days and creditor days in showing cash-flow timings.

Asset turnover sales / net assets

This ‘secondary ratio’ from ROCE (see above) assesses the value of sales generated by the net assets representing the capital being employed in the firm. It illustrates how efficiently the firm is using its assets to generate turnover.

Debt and gearing

The debt ratios show how much the company owes in relation to its size. This analysis indicates whether lenders are likely to loan additional funds given the level of the company’s debt. Gearing is important when additional capital is required.

If a company is already highly geared, it may find it difficult to take out further loans. Also, the more highly geared the company, the greater the risk that the shareholders will not receive a dividend distribution. A highly geared company having external loans may find that, because it must pay a large amount of interest annually, the lenders force it to sell assets to generate payments: if their loans are secured on assets, they may remove the assets if interest payments are not met.

Debt and gearing ratios

Debt ratio = Ratio of total debts to total assets

50% is often regarded as the generally accepted maximum figure: again, an important consideration is whether this figure is rising or falling.

Gearing = prior charge capital / total long-term capital (long-term loans + preference shares)

Looks at the relationship between borrowing and fixed assets. This is an efficiency ratio

This analyses the different types of payments made to capital. Companies with more than 50% prior charge capital are called ‘high-geared’: those with less than 50% are ‘low-geared’.

Gearing Ratio = Long term loans / Capital employed x 100

The higher it is the greater the risk the business is under if interest rates increase

Debt/equity ratio = prior charge capital / (ordinary share capital + reserves)

This gives similar information to the gearing ratio.

Interest cover =  PBIT / interest charges

The interest cover ratio shows if the company is making sufficient profits (before interest and tax) in order to pay interest costs easily. A company’s gearing should be assessed from the differing viewpoints of the directors, the investors (shareholders), and the actual and potential lenders.

Investment

Actual and potential shareholders are interested in assessing the value of an investment in (ordinary) shares of a company. Since the value of a listed company is its market value, some of these ratios take account of the share price as well as the information in the published accounts.

Shareholders are normally interested in two aspects of their investment:

• the share price (any increase here provides capital growth), and
• the dividend received, which forms the income element.

As a result, companies can often be under pressure to adopt policies that will ensure adequate short-term profits (e.g. to finance dividend distribution): this may conflict with their plans for long-term growth.

Investment ratios

Earnings per share (EPS)  = profit available for ordinary shareholders / number of ordinary shares

This represents the return on each ordinary share, and is nowadays stated in the published accounts.

Dividend cover =  EPS / net dividend per ordinary share

The dividend cover shows that proportion of profit available for ordinary shareholders which has been distributed, and that proportion which has been retained to help fund future growth. For example, a cover of two times indicates half the available profits have been distributed and half retained.

Price/earnings (P/E) ratio =  Ratio of the current share price to the EPS

The higher the P/E ratio, the greater the confidence shareholders have in the company. It is particularly important to compare this ratio to those of other companies in the same industry.

Dividend yield = share dividend for the year / current market value of the share (ex dividend)

This indicates the return the shareholder is expecting on the share.